Monthly Archives: September 2008

The US House of Representatives has voted to reject the Emergency Economic Stabilization Act – the $700bn Treasury-funded facility for purchasing and managing toxic assets held by the US banking system.

Opposition to the proposal came from two different sources. A few remaining libertarians and believers in unfettered free enterprise voted against. Even when they recognise the risk that a calamitous collapse in economic activity may result, they view this as a form of creative destruction that is an integral part of a Darwinian market economy. I don’t know anything about Gresham Barrett, a Republican congressman from South Carolina but his statement fits the bill: “My fear is the government will be forever changing the face of the American free market. Because I believe so strongly in the principles of the free market and the belief in freedom, I will be opposing this bill.” Those who genuinely hold these views are mad, but honest and principled. I wish them a good depression.

The most important financial crisis-related news this morning is not the tentative agreement on TARP-lite reached over the weekend in the USA. At best this is a holding operation that buys (a little) time for the US banking system while the industry and the authorities figure out how to recapitalise the banking sector. It is also not the nationalisation of Bradford and Bingley, a systemically unimportant UK bank specialising in residential and buy-to-let mortgages. B&B is less than half the size of Northern Rock (at its peak). The nationalisation demonstrates that the UK government will not let even the smallest remaining deposit-taking bank go under. By the British tax payer effectively underwriting the entire UK banking system, the authorities now may have a short window of relative calm to decide on the further consolidation and recapitalisation of the UK banking sector.

The most important development was, however, the rescue of Fortis through the Belgian, Dutch and Luxembourg governments taking 49% equity stakes in Fortis’s banking operations in each of these three countries. The ability of the euro area fiscal authorities to co-ordinate on a bail-out for a bank with not-only strong cross-boundary operations, but indeed with a strong multi-national (almost supranational) identity was untested until today. They passed the test. Everyone who mattered, the national monetary authorities, the President of the ECB, the national regulatory authorities, the three national ministers of finance and the President of the Eurogroup chipped in and played their part.

Especially remarkable is the fact that it took much less time and effort to put together the multi-country fiscal rescue effort of the three EU member states than it took to cobble together the son-of-TARP in the US. Incipient federalism triumphs over disfunctional established federalism.

A bad day for Benelux banking. A great day for European cooperation and unity.

With a banking crisis in full swing, the US Congress futzes around as if it has all the time in the world to come up with a solution. Perhaps the demise of Washington Mutual – the largest ever failure of a US deposit bank, will motivate the Congressional sloths to move forward. Populists will have to put their desire for bankers’ blood on hold. Libertarians will have to swallow hard and think of Ayn Rand. Unless you really want to be able to tell your grandchildren stories of how you coped with the hardships of the Great Depression of the 2010s, the TARP proposal should be passed.

UK prime minister Gordon Brown believes that the financial crisis that now threatens to destroy the UK banking system is just the spill-over of the residential mortgage financing crisis in the US and is manageble with the existing institutions, arrangements and policies. According to the prime minisnter, the UK banking sector and financial system are sound. He sees no need for a US style TARP or similar facility, let alone for further radical proposals for recapitalising the banking system through the injection of capital by the government, in exchange for a government equity stake, or through a mandatory conversion of bank debt into equity. With Bradford and Bingley about to share Northern Rock’s fate (unless a private solution can be found at the last minute), one hopes prime minister Brown may exit from his state of denial.

In the rest of Europe, the financial crisis is considered an essentially Anglo-American problem, whose spillovers to the euro area and other parts of the European continent are limited to some careless exposures on the asset side of the balance sheet to the US subprime markets. With a number of large banks domiciled in small continental European countries tottering near the edge of the abyss, one hopes that the public protestations of confidence are not preventing the preparation of emergency rescue plans to prevent a financial meltdown.

In the UK, as in the US and much of continental Europe, the liquidity crunch has become but the epiphenomenon of the threat of insolvency of a large chunk of the banking sector (‘banks’ being defined broadly to include such companies like AIG and GE, which in addition to their non-banking activities, have become engaged in highly leveraged financial intermediation involving massive asset-liability mismatch.

Since solvency is the main issue now, the central banks are no longer central to the management of the crisis. At most they can act as the agents or hand-maidens of the fiscal authorities, offering their expertise and reputations, but not their financial resources.

On the Vox blogsite of the Centre for Economic Policy Research, I have written a piece called The Paulson Plan: a useful first step but nowhere near enough. The title is rather self-explanatory. In the blurb preceding the column it reads: “The Package also needs some goodies for US homeowners”. The column in fact argues the opposite. The populist, re-election oriented faction of Congress is asking for such goodies and they may be politically necessary to get the rest of the plan through, but both from an economic efficiency and from a fairness perspective, sops to over-stretched mortgage borrowers are undesirable.

It’s time to revisit the ‘Five Tests’, to declare them passed and, subject to the UK being deemed, by our EU partners, to meet the Maastricht criteria, for the UK to adopt the euro.

Remember the ‘Five Tests’ designed at the behest of then Chancellor Gordon Brown (whatever happened to him)? Passing these economic tests was presented as a necessary condition for the UK to apply for full membership in the Economic and Monetary Union (EMU).

For those who have a life and therefore don’t remember what the Five Tests were, here they are again:

Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?

If problems emerge is there sufficient flexibility to deal with them?

Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?

What impact would entry into EMU have on the competitive position of the UK’s financial services industry, particularly the City’s wholesale markets?

In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?

It’s too bad that what the Bank of England does well – setting the official policy rate (Bank Rate) – is much less relevant to our economic wellbeing in this crisis that what it does poorly – maintaining financial stability through liquidity management. Adding to the vulnerability of the UK’s financial system, the UK Treasury continues to stand on the sidelines, fiddling while London burns.

With the real economy slowing down and inflation showing signs of softening at last, interest rates will be cut. The Treasury also knows enough basic macroeconomics not to engage in active pro-cyclical behaviour by raising taxes or cutting spending today. Tax increases and spending cuts will have to wait until, sometime in 2010, the economy strenghthens again. The combined actions of the Bank of England and the Treasury, however, will do little or nothing to unfreeze key financial wholesale markets, including the markets for securitised residential mortgages, or to recapitalise the tottering British banking system.

The $ 700 bn requested from Congress by Treasury Secretary Paulson to buy up bad mortgage-backed and mortgage-based securities from American banks is not going to solve the crisis, although it can be part of a solution. I assume that $700 bn will allow the purchase by the US Treasury (or its agents) of at least $2 trillion worth of mortgage-related securities at face value, as it would not make sense for the US tax payer to pay much more than 33 cents on the dollar for the mortgage-related rubbish that banks have loaded onto their balance sheets. Pricing the assets punitively makes it possible to save the financial system while punishing the financial sinners at the same time. The right time to address moral hazard is always now.

The proposal to create a government-financed agency to take the most toxic assets (such as subprime and Alt-A RMBS) off the balance sheets of the US banking system is not unexpected. The US Treasury is in fact already running a pilot scheme for this twenty-first century version of the RTC; it has been stepping up direct purchases of Fannie and Freddie mortgage bonds in the last couple of days.

But the scale of the additional proposed scheme (which I shall refer to as the Toxic Asset Dump (TAD, to mirror the TAF run by the Fed), which could easily reach $ 1 trillion or more, is likely to be much larger than the Treasury’s outright purchases of GSE mortgage-backed securities. Together with the US government’s blanket guarantee of the $3.4 trillion money market mutual funds (backed up initially with $50 billion of Exchange Stabilisation Fund resources), the socialisation of financial sector risk in the USSA is proceeding apace. We can expect a similar proposal for a publicly funded TAD in the UK before long.

Panic is not a pretty sight, whether it involves disco-goers trying to escape a burning building through a narrow locked door or financial lemmings rushing for an exit at any price. But panic we we have in the financial markets. Banks are unwilling to lend to each other and no-one is willing to lend to banks. Libor-OIS spreads (even overnight) have gone through the roof. Fear of counterparty risk is has spread far and wide among financial market participants. Liquidity is being hoarded instead of traded to those most in need of it. A growing number of financial institutions have been confronted with the reality of Keynes’s saying that “the markets can stay irrational for longer than you can stay solvent”. Even fundamentally sound institutions (that is, institutions whose assets, if held to maturity would be more than sufficient to finance all outstanding obligations) are experiencing the truth of the corollary to Keynes’s saying: “the markets can stay irrational for longer than you can stay liquid”.

The monetary authorities are doing the right thing by drowning the markets in central bank liquidity. In New York, London, Frankfurt, Tokyo and Moscow they are injecting large amounts of liquidity into the overnight and longer-term money markets, often against a wider range of collateral than in the past. I expect to see increased cooperation of swap lines among central banks, especially swaps between the Fed and the main European central banks to make US dollar liquidity available to banks domiciled in Europe before the US markets open.More may have to be done. For a while, the interbank markets may have to be de facto replaced by a hub-and-spoke system of borrowing and lending with the central bank in the centre and private banks at the spokes. If the banks don’t trust other banks as counterparties, direct lending and borrowing between banks may have to yield, until confidence is restored, by indirect inter-bank lending and borrowing via the central bank, with the direct transaction between bank A and bank B replaced by a sequence of transactions between bank A and the central bank and bank B and the central bank.

Governments and regulators are bending, relaxing or suspending the rules to prevent fresh financial disasters. Some of this makes sense. The Fed as regulator suspended a regulation that prevented a commercial bank from making a loan to its investment bank subsidiary. This was clearly necessary for the take-over of Merrill Lynch by Bank of America to go ahead. The British government waived the competition policy (anti-trust) impediments to Lloyds -TSB’s take-over of HBOS.

Some of it makes no sense. The closing of the stock market in Moscow suggests that the authorities there believe that if you cannot observe the valuations put by the markets on Russian listed companies, these valuations will go away or could even improve spontaneously. It may of course be a wheeze to stop marking to market of the shareholdings of the new nomenklatura.

The proliferation of restrictions on short selling are another triumph of populism over sense. Not for the first time, the collapse in the share price of a number of politically well-connected banks and other financial institutions has raised an outcry about short selling – the practice of selling shares you don’t own in the expectation of buying them back in the future at a lower price. A regular short seller borrows the shares he sells, hoping that the future spot price of the shares will be sufficiently below the current price to cover the carry cost of borrowing the shares. A naked short seller doesn’t even borrow the shares he sells. That sale then obviously cannot be a spot sale of shares, because you don’t own any, you haven’t borrowed any and therefore cannot deliver any. It is instead a forward sale, a commitment today to deliver a certain number of shares at some future date at a price fixed today. You hope to buy, in the spot markets between today and the delivery date, at a price below the agreed forward price, the shares you have sold forward.

Are short sellers greedy pigs? No more than ‘long buyers’ (e.g. all home owners) are greedy pigs. They are just normal, naturally greedy mammals. Should collusion between short sellers be banned? Of course it should, like all forms of collusive behaviour aimed at influencing prices, unless explicitly authorized by the authorities. Trash and trade tactics (spreading rumours you know to be untrue in the hope of benefiting from any resulting price movements) should also be illegal. In most countries such behaviour is in fact illegal. The offense is, however, very hard to prove. Any interference with the freedom to speculate should be symmetric, applying equally to short sellers and to those taking long positions.

The fiscal authorities are dipping into the deep pockets of the tax payers to find resources to back up guarantees or to recapitalise failing systemically important banks and other financial institutions.

It is key that this be done in a way that saves the institution assumed to provide the public good, while minimising the adverse effect on future incentives for risk taking. Things are improving here. The £85 billion bridge loan from the Fed to AIG is both expensive (850 basis points over Libor for a 2-year facility) and overcollateralised. The shareholders have been comprehensively diluted. There will be no dividend payments and control over all major decisions rests with the government, which owns 79.9 percent of the shares (the highest fraction that does not trigger a legal event of default, which would have nasty implications for the CDS markets). The management is gone. The only feature missing from a moral hazard perspective is a charge on or haircut for AIG’s creditors. There should be a cost to all providers of funds to AIG, not just to the shareholders. But that’s a rather minor blemish in an otherwise quite elegant design.

From a long-run financial stability perspective, the decision not to put public money behind a bail-out of Lehman Brothers also would seem to be the correct one. While it may well have increased short-term volatility and uncertainty, the deleterious effect of tax payer support for a bank that was not systemically significant on incentives for future investment, lending and borrowing would have been horrendous – an open invitation for excessive risk taking.

The creation of a $70 bn private liquidity support fund by 10 large banks (Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Merrill Lynch, Morgan Stanley and UBS, each of which pledged $ 7 bn to the scheme) will also be helpful from a short-run stability perspective, although the arrangement is fraught with risk of abusive collusion. Each bank (though not, I assume, more than three banks at a time) will be able to borrow up to a third of the $70 billion. The absence of Japanese and Korean banks is striking. I expect some of them to join the scheme before long. Other large European banks may also sign up.

Beyond flooding the markets with liquidity, recapitalising systemically important institutions with tax payers’ money (while wiping out their shareholders, imposing a charge on their creditors and firing the top management), lending their good offices for putting together defensive mergers and take-overs of vulnerable institutions, there isn’t much the authorities can do for now.

If things fail to improve, the central bank may, as discussed above, take over the role of the interbank market. It at least it is an acceptable counterparty for all private banks. If that does not do the job, a more comprehensive socialisation of the key institutions in the financial sector may have to be contemplated. Societies cannot afford to let financial sector paralysis cripple the real economy.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.